Six weeks can be a long time in financial markets and central bank policy. Between the December monetary policy meeting, when the U.S. Federal Reserve raised interest rates for the fourth time in 2018, and its decision to hold rates steady on January 30, 2019, the central bank did a complete 180-degree turn. After strongly indicating in December that interest rates would have to rise this year, the most recent statement removed references to further gradual increases and noted that inflationary pressures are muted. The implication could not be clearer: Fed policy is on hold for the foreseeable future.
Currency and bond markets had sniffed out that dovish pivot by the Fed, selling the U.S. dollar heading into the policy meeting and bidding up the prices of bonds. Market participants in aggregate seem to believe the Fed is done hiking rates for the entire cycle. With markets currently pricing a chance of rate cuts this year, one could be forgiven for thinking that the dollar bull run has ended. Several times in recent months, the U.S Dollar Index (DXY)1 could not overcome resistance at 97.7 (see chart below), making it potentially vulnerable to a larger setback.
However, we believe that pessimism around the U.S. economy is overdone and we expect another leg up in DXY that could take it to 98, possibly to 100, before its bull run ends for this cycle. Our baseline outlook is that economic growth will stabilise and a tight U.S. labour market, coupled with accelerating wage inflation, will exert further upward pressure on consumer prices. Meanwhile, the European Central Bank (ECB) and the Bank of Japan (BoJ) have also become more dovish, weighing on the euro and the yen.
Other major currencies
As the budget crisis in Italy faded into the background, new factors weighing on the euro have emerged. Data flow for eurozone growth and inflation has been weak in early 2019. Some of the softness in economic activity was driven by idiosyncratic shocks that are now in the rearview mirror. For example, changes in emissions standards temporarily impacted German auto production. The impact of these transitory factors should fade over the coming months. However, muted inflation in the eurozone allowed the European Central Bank (ECB) to rule out interest rate increases for all of 2019.
All this keeps the euro under pressure in the short term, although cheap valuation of the currency probably limits the downside. We believe that buyers of the euro will re-emerge if the EUR/USD exchange rate touches 1.10 from 1.13 as of March 15, 2019.
UK pound sterling (GBP)
As of March 16, the pound has been the strongest major currency in 2019. The appreciation of sterling this year has been driven by increasing optimism about an imminent benign Brexit outcome. On March 12, Prime Minister Theresa May’s deal with the European Union to enter an orderly transition period was rejected by the British House of Commons for the second time. However, on the following two days a majority in the UK parliament voted against a no-deal Brexit and in favor of postponing the departure date from March 29 to June 30. A delay on its own just moves the no-deal cliff edge a few months back. Ongoing Brexit uncertainty is detrimental to the British economy, and we can already see its impact in the data. Corporate confidence is low, which prevents businesses from investing. The consumer is pessimistic, slowing demand for durables like houses and cars.
For the sterling rally to live on, we need either a deal to pass in the next few weeks or the discussion to shift toward a softer Brexit/people’s vote.
Japanese yen (JPY)
The yen is an attractively valued currency that we like for its diversification properties. As of February 28, 2019, the yen was 9% cheap vis-à-vis the U.S. dollar on the purchasing power parity measure2. If equity markets sell off, we believe that the yen will be the best safe-haven currency. It is traditionally a defensive asset, due to its net foreign creditor position, which causes repatriation of capital during times of crisis. The defensive nature of the yen is likely to be compounded by its low carry. During good times, investors engage in so-called carry trades where they buy high-yielding currencies like the Australian dollar and use the yen as a funding currency. Unwinding of carry trades during bad times would give the yen a major boost, in our view.
We would stay long yen or increase our allocation when the exchange rate versus the U.S. Dollar weakens toward 114 (from 111.4 as of March 15, 2019).
1The U.S. Dollar Index (DXY) is a measure of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The index goes up when the U.S. dollar gains "strength" (value) when compared to other currencies.
2Source: Organisation for Economic Co-operation and Development (OECD), as of March 15, 2019.